The more things change, the more they stay the same

Central bank resolve is about to be tested and the US Federal Reserve in particular may need to choose whether it prioritises price stability or financial stability.

"Inflation remains well above target in most of the developed world … we continue to question how US and European central banks can pause, let alone cut monetary policy rates just yet.

Financial markets were in Pandemonium in early March as the 16th largest US bank, Silicon Valley Bank (SVB) collapsed. Only a week later, 167-year-old Swiss institution Credit Suisse was forced into an arranged marriage with neighbour and long-time rival UBS.

News headlines were questioning whether the next great financial crisis was upon us; bond market volatility hit overdrive and two-year Treasury yields experienced the sharpest week-on-week decline since the Black Monday crash of 1987.

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Where only a few weeks earlier the market had completely discounted any prospect of the US Fed easing its policy rate in 2023 – and had priced a terminal rate of almost 5.7 per cent – suddenly there was an expectation of no more rate hikes and 100 basis points of easing before year-end.

Yet despite the calamity, the S&P 500 remains more than 7 per cent higher on a year-to-date basis and equity market volatility has fallen significantly. Perhaps most tellingly, for all the talk of dramatic change, the biggest conundrum for global markets remains – inflation.

In the US, the core consumer price index (CPI) continued to decelerate for the fifth consecutive month in February, to 5.5 percent year-on-year. However, the ‘stickier’ component – services inflation – has continued to gather momentum and may not have peaked, remaining unchanged from the month prior at 7.6 per cent year-on-year in February and at its highest level since August 1982.

Last month we spoke about the three broad scenarios highlighted in our 2023 Global Market Outlook. Despite the recent crises, we believe the second of our three scenarios continues to remain most probable – namely, inflation pressures force central banks to keep tightening.

Inflation the priority

Inflation remains well above target in most of the developed world and despite the natural tightening of credit and implied monetary tightening that is likely to transpire because of the bank failures. We continue to question how US and European central banks can pause, let alone cut monetary policy rates just yet.

That said, uncertainty is currently the one constant and only a month on from almost discounting scenario one, the financial conditions brought about by the crises could bring this to fruition. In fact, the bond market is currently trading like this is the case.

Though it’s still too early to conclude whether this will eventuate, the impact on financial stability and knock-on impact to economic growth and potentially inflation will need to be watched closely in the months ahead.

As we have spoken about for many months, central banks have yet to be truly tested this cycle. In the US, although unemployment has lifted modestly to 3.6 per cent from its 50-year low of 3.4 per cent in January, demand for workers remains strong.

Market pricing has shifted dramatically and is now pencilling in significant cuts in H2 2023

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Likewise, wages growth, although cooling, remains robust. The most recent S&P purchasing managers’ index (PMI) are perhaps most telling. After trending downwards for most of 2022, the flash S&P composite PMI rose to 53.3 in March, up from 50.1 previously, and tells a similar story of strength in services.

Domestically, inflation pressures continue to paint a somewhat different picture. The most recent labour force report showed a large bounce in employment and a fall in the unemployment rate to 3.5 per cent from 3.7 per cent previously.

However, retail sales were softer at +0.2 per cent month-on-month and the monthly CPI continued to cool, rising 6.8 per cent in the year to February 2023. With inflation pressures less advanced than overseas, the Reserve Bank of Australia made the decision to pause its tightening cycle in April - although it has firmly noted that some further tightening of monetary policy may well be needed to ensure that inflation returns to target.

Uncertain outlook

From a market perspective, equity and bond markets continue to push different narratives. Yield curves have fallen dramatically since the demise of SVB, inferring that economic conditions are soon going to become troublesome.

Conversely, equities are yet to fully price the possibility of recession and are either looking through or unwilling to accept such a gloomy outlook. Earnings expectations are still discounting the expected pressure on margins and falling demand that would likely hit in such an environment.

For context, US earnings per share have fallen 23 per cent on average over the past four recessions. Currently that metric is down only 6 per cent.

So, is the equity market or bond market right? The answer probably lies somewhere in the middle. But with an elevated level of uncertainty currently permeating markets and with central banks appearing to lean towards prioritising price stability, we remain defensive across portfolios this month.

Last month, we increased our global and domestic bond allocations just prior to the sharp retracement in yields. This has served portfolios well since and both positions have drifted higher again owing to outperformance.

Although we expect yields to have likely peaked in the US, further monetary tightening is expected across the globe, and with risks elevated we have again increased our targets for both positions. As a result, we hold onto our positioning this month and have become more defensive across portfolios overall.

We are underweight in risk assets and mildly underweight in both Australian and domestic shares within portfolios. Across defensive assets we retain our preference for Australian bonds and cash this month.

Click here to read the full 2023 Outlook report

Lakshman Anantakrishnan is Head of Investment Strategy, Private Banking & Advice at ANZ.